The Strategist

Second round of Canada's housing bubble

05/02/2017 - 15:47

Fate of the largest Canadian non-bank mortgage lender Home Capital Group has been determined over the weekend.

The company faced an outflow of almost 70% of deposits, and announced attraction of an extremely large credit line for 2 billion Canadian dollars to provide liquidity. The situation frightened the shareholders, the papers fell by 10% and destroyed two-thirds of the company's market cap in two weeks.

Fears about the possible spread of the crisis rang an even more alarming bell. Equitable Group, another non-bank mortgage lender, said that customers raised an average of C $ 75 million from Wednesday to Friday, which was 2.4 percent of the total deposit base.

As the recent HCG study showed, this once again shows how fast outflow can be.

Given that the liquid assets after the outflow amounted to 1 billion Canadian dollars, the company also announced a newly opened extraordinary credit line of 2 billion Canadian dollars.

After these actions, Equitable’s credit terms became more favorable than those of Home Capital, which effective interest rate starts from 22.5% when using a line for 1 billion Canadian dollars.

Of course, given the historical credit losses, Equitable will be considered quite safe, but Home Capital Group is still in the same boat.

After the news of Equitable’s loan were published, the rally of the lender's shares was 26%, to 46 Canadian dollars, in Toronto, helping to offset a portion of 41% decline occurred in last week.

Other shares of Canadian lenders that collapsed last week also rose on Monday. For example, First National Financial Corp. mortgage lender added 2%.

Thus, while Canada's investors and regulators are exhaling in relief and hoping that everything is returning to normal, the attention is gradually being shifted to Home Capital’s bonds.

At the same time, the market continues to monitor the situation with Equitable and other non-bank lenders to make sure that the panic has subsided.

Bloomberg reports that bonds maturing in December of the following year were trading at 90.6 cents to the dollar on Monday, yielding 10% compared to less than 3% on 19 April.

The largest risk remains for HCG long-term deposits of 12.8 billion Canadian dollars, which are necessary to finance the mortgage business and account for 1% of the Canadian mortgage market. The outflow can accelerate.

What will happen in the worst case? Decrease in deposits may lead to liquidation of the company, which will be controlled by the federal bank’s regulator, Office of the Superintendent of Financial Institutions.

On Thursday, the lender said that it hired BMO Capital Markets and RBC Capital Markets to compile an overview of the strategic options, suggesting that negotiations on the sale could begin.

Care for the viability of HCG has fallen on the Canadian government’s shoulders, said Canadian Finance Minister Bill Morneau in his statement. He added that he is "closely" following the situation with Home Capital.

Funding issues of Home Capital have not yet been finally resolved. The details will be disclosed in the next 30-60 days.

However, this may be a hint of government support. Apparently, this prompted Home Capital to announce that it is connected with Toronto’s Turtle Creek Asset Management Inc. which owned 14% of Home Capital as of the end of February.

"We are unhappy with the latest developments in Home Capital, but are still committed to long-term relationships with our fellow investors", said representatives of Turtle Creek Asset Management Inc.

Well, as long as "fellow investors" are comfortable with a short-term drop in value, everything should be fine.

Strangely enough, the "best" possible outcome for investors would be the worst. In other words, contamination and outflow would force the government to intervene and do what the US authorities did almost a decade ago, that is, to conduct a bail-out not only of the Canadian housing market, but also of its insolvent mortgage lenders, as well as of any other banks and financial institutions.